A valuer’s angle on leasehold enfranchisement

The valuer in leasehold enfranchisement has an extreme version of the valuer’s usual problem: to steer a course between the vagaries of market observation on the one hand and detachment from reality on the other. The extra difficulty in leasehold enfranchisement is the artificiality of some of the statutory assumptions the valuer must work with.

That this problem is severe is illustrated by the two most important decisions of the Upper Tribunal (Lands Chamber) (“UT”), formerly Lands Tribunal: Sportelli and Mundy. In the former, the Tribunal utterly rejected market observation in favour of a financial construct; in the latter, they completely rejected modelling in favour of adjusted market observation.

What is valuation?

Schedule 6 to the Act requires the valuation of the freeholder’s interest by assessing

… the amount which at the valuation date that interest might be expected to realise if sold on the open market by a willing seller …

While this is the definition the valuer works with in carrying out the statutory valuation, the reference to the open market is a reference to market value, the nature of which is amplified and refined by the Red Book definition:

The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion.

Valuing the freehold interest with vacant possession in a house for mortgage purposes is no different in principle to the assessment of a value in leasehold enfranchisement. If the house next door was recently sold and it’s very similar, that gives an extremely good guide to the value of the house the valuer is assessing. Note that this says nothing about what the valuer thinks the future of house prices will be, whether the house is “good value” in the sense of representing a high degree of utility for the purchaser, or whether he feels that the current level of house prices is alarming. Indeed, it says nothing about any general principles at all.

This is a straightforward example of how valuers proceed. They actually don’t deal in the interesting questions of “how?” and “why?”, nor social, economic or personal merit. They simply apply the results of an actual market transaction to the subject matter of their valuation, without getting into what might well be more stimulating intellectually. Valuers merely observe, analyse, adjust and apply. There are robust, practical reasons for this, implanted at the very earliest stages of a valuer’s education. Investors may regard a given market price (that’s to say what valuers confusingly call “value”) high or low relative to their perception of the true or intrinsic value of the property concerned; they may become sellers or buyers accordingly. For valuers to think this way is inconsistent with their function (see the Red Book paragraph 2.6). Valuers must keep judgment to a minimum, using it mainly in the area of adjustments.

It follows that comparable evidence is the core concept in property valuation. What the valuer does is to collect comparable information, analyse it, adjust it and apply it to the subject problem. This may be more or less difficult in any given case, but that is the universal technique, and for sound reasons. In many situations, were the valuer to substitute his personal attitude to the property for that technique, he would be likely to get the valuation wrong and, in an extreme case, could expose himself to a claim for professional negligence.

Of course, in practice data can often be quite difficult to come by. The more unusual the kind of property – the more specialised the class of property being valued – the more difficult it may be to find comparable evidence. The sources of such evidence are many, particularly in central London. There are many websites which collect data from other sources: LonRes from agents for example; myhouseprice.com from the Land Registry; the Land Registry itself; other agents known to the valuer; and the transactions of which the valuer is aware in his or his firm’s capacity as agent.

So important is the collection of comparable evidence that a valuation without any forces the valuer to doubt the accuracy and range of his valuation. For this reason, valuers are sometimes compelled to rely on a single comparable, exposing them to the “one swallow doesn’t make a summer” criticism. Better that than theorising about what value might be. The relevance, quality and ranking of comparable evidence is of paramount importance in valuation. Closeness to the subject matter is critical in assessing value. Remoteness of comparable evidence from the subject matter to be valued would imply that there is absolutely no comparable evidence of any useful kind.

Making judgments about adjustments to comparables to arrive at the value of the subject property is perhaps the only area in which the valuer exercises a truly intellectual function. The rest is just well-considered evidence-gathering. Adjustments to valuation data are a matter of routine for valuers. It’s not necessary – in fact it’s usually not possible – to find comparable evidence precisely the same as the subject property. Indeed, the more evidence the valuer has to work with, the more internally inconsistent he is likely to find that evidence. The real world is a messy place. Transactions tend to fit a scatter graph better than a line, and it’s this “scatter graph” that the valuer is dealing with in arriving at his figure.

A good quantity of comparable evidence, adjusted by a valuer, even if speculatively or tentatively, is more likely to be satisfactory than wholly speculative, theoretical or tentative assessments. A valuer’s technique is therefore rooted mainly in fact, rather than in speculation.

The problem is that leasehold enfranchisement is a world set apart from the workaday world, and all sorts of non-market assumptions have to be made.

Types of transactions

There are three types:

The compulsory acquisition by a lessee of a 90-year extension to the lease of his flat, the ground rent during the old and new terms being eliminated in the process.

The enfranchisement of blocks of flats by a majority of lessees in a qualifying building. The lessees, or more accurately the nominee purchaser who buys the freehold for them, acquires the freehold subject to a leaseback to the old freeholder of certain elements in the building on 999-year leases at a peppercorn. The participants in this transaction are entitled as of right to a 999-year lease of their flat at a peppercorn. When it becomes the new freeholder, the nominee purchaser then grants each participant a 999-year lease of his flat.

The acquisition of the freehold by lessees of houses.

Elements of price payable

In each type of transaction, there are three elements to the price payable by the lessee:

The interest the landlord is losing must be paid for. Broadly, this involves capitalisation of the ground rents payable over the term of the lease, and an assessment of the present value of the landlords’ reversion (or reversions, if there is more than one landlord with a reversion). Strictly speaking, it’s the diminution in the value of each landlord’s interest which is calculated. This is obviously the whole value in the case of blocks of flats, except where parts are leased back. It is also the whole value in the case of houses. In practice, it is almost the whole value in the case of lease extensions: the landlord retains a reversion, albeit a very distant one, one the lease extension has completed.

If the lease has less than 80 years to run at the date of service of the initial notice of claim (and the lessee is participating, in the case of collective enfranchisements), then 50% of any marriage value has to be paid. Marriage value is calculated by adding up the value of all the interests of the lessee and his landlords before the transaction, and comparing that with the value of all the interests after the transaction. The difference is marriage value. The lessee pays half of it, in addition to the value of the landlords’ interest.

Though rare in practice, there is also provision for losses which landlords suffer, other than in respect of the property itself. This could arise, for example, where the removal of one freehold from a group of freeholds held by a landlord has an adverse effect on the development value of his other freeholds.

The main components of price payable

Though the factors entering into a leasehold enfranchisement calculation are many, the basic and most common ones are these:

Freehold/long leasehold value

As more and more leasehold enfranchisement takes effect, as it has in Central London for example, the quantity of market evidence at the freehold or near-freehold level increases. Whereas at one time it was almost impossible to find freehold or long leasehold evidence on a given estate, it is becoming increasingly easy to make observations in the market of what flats and houses sell for at that level. For this reason, though there is always scope for disagreement, the evidence obtained at this level is probably the most convincing in market terms. The only adjustment to be made to actual sale prices is for lessees’ improvements, which are disregarded. It is probably at the freehold or near freehold level that the market observation approach to valuation is at its strongest.

Short/current leasehold value

There are usually a few short leasehold transactions to be observed in the real world. However, a double adjustment is required to these observations: first for improvements, as mentioned above; and second for the benefit of the Act itself. The Act’s draftsman allowed for the possibility that the Act itself would tend to enhance short leasehold values to the detriment of landlords. The valuer was therefore charged with assessing what the short leasehold value might be without the benefit of the Act.

Here we depart from market observation. It is necessary to make an adjustment for something that does not exist in the real world. In the real world, the sale prices of flats and houses at the short leasehold level are influenced by the fact that the purchaser can expect to acquire an extended lease or the freehold, as the case may be, under the Act. The reader might well suppose that valuers could fairly easily agree on the adjustment required for the benefit of the Act, but regrettably that is not so. The range of adjustment must vary with the length of the lease. For example, the Act may have only a slight influence on the value of a 75-year lease, but a great influence on the value of, say, a 30-year lease. In Nailrile and Mundy, the UT decided that the decision in Arrowdell was right: we have to do our best with market evidence. One can also look at graphs.

In82 Portland Place, the UT decided that the agreed market relativity of 41.25% should be adjusted by 20% to 33.00% to remove the benefit of the Act.

In Mundy, the UT decided that, if graphs were used, the Gerald Eve and Savills graphs were to be preferred. The Gerald Eve graph had influenced the real market, and was therefore at the forefront.

Deferment rate

Deferment rate was reviewed in Sportelli. In this case, the UT sought to set a standard deferment rate which should endure until some of the major influences it identified changed significantly. Three propositions emerged from this case:

Deferment rate in the case of houses should be 4.75%.

Deferment rate in the case of flats should be 5.00%. However, note that Zuckerman (a case in Birmingham) suggests that it can sometimes be a bit higher. More complex calculations are required if the unexpired term is less than 20 years.

Landlord’s hope of marriage value was not lawfully a factor that should enter into the calculation of the value of the landlord’s interest.

Deferment rate was defined by the valuers during the course of the case as:

The annual discount applied, on a compound basis, to an anticipated future receipt (assessed at current prices) to arrive at its market value at an earlier date …

The Tribunal appeared to approve this definition.

So, if I want to know the present value of the right to recover vacant possession of a flat (for example) in 25 years’ time, I can apply the deferment rate of 5.00% to that flat, annually and cumulatively for each of the 25 years that the freeholder has to wait. Note that the value which is used for this purpose is not the value the flat will have in 25 years’ time, which by definition is unknown, but the value it has today. Since the future value is unknown and, unless one interviews the purchaser, his perception of what it will be is unknown, all one can do is relate it to the value the flat has now, freehold with vacant possession.

In Sportelli, the UT decided that landlord’s hope of marriage value was not a legitimate element for inclusion in the valuation of the landlord’s interest. In the real world, some part of the price investors pay for freehold reversions is attributable to hope of marriage value. They buy hoping that at some time in the future they will be able to do a marriage-value-releasing transaction with their tenants, and thereby make a profit on what they paid – so much so that they are prepared to share some part of that anticipation or “hope” of marriage value with the vendor from whom they buy.

So the landlord’s interest is valued by reference to something artificial, unlike the tenant’s interest.

Capitalisation rate

Sportelli did not deal with capitalisation rate at all, so this remains an open issue. There are probably three types of ground rent income.

The first is an income which is fixed for the term, or where the lease specifies what escalations there are to be in rent, and defines them in money from the outset.

The second type of ground rent income is what valuers are wont to call “dynamic”. This means an income which relates in some way to the value of the property. Sometimes one encounters rent review provisions at intervals as close as 20 years, at which the value of the property will be assessed and the ground rent related to it, either as a small percentage of the vacant possession value of the unit in question, or at a rather larger percentage of its rental value. Over the lifetime of the lease, the investor can expect that clauses of this kind will tend to align the income from the property more closely with the growth in property values, rather than fixing it and thereby potentially eroding it with inflation. It can be expected that a buyer of such ground rents will be prepared to accept a lower initial yield on the second type of ground rent income than on the first.

The third, an intermediate type of income, is where the ground rent is reviewed, but in ways unrelated to property value. One example of that is a ground rent linked to RPI, rather than to property values. It seems reasonable to expect that the capitalisation rate for such an income would lie somewhere between the extremes of the low rate for the dynamic income, and the high rate for the fixed or fixed escalating income.

Other considerations

There is no space in this article to go into some of the more obscure areas of leasehold enfranchisement, but it’s useful to log some of them:

Improvements

As mentioned, these are to be disregarded under the Act, and disregarded in all their influences on value. These are not only freehold and short leasehold values, but also any rental elements which are based upon such values, or which are related to open market rent, for example.

Low value houses

Historically, most accounts of leasehold enfranchisement begin with the enfranchisement of low value houses under section 9(1) of the Leasehold Reform Act 1967, section 9(1). This is because the experience of older practitioners in the field is rooted in that legislation. However, the advantage to the lessee of enfranchising under 9(1) was so great that by and large this remains relevant only to corporate and non-resident lessees, who were unable to enfranchise before the Commonhold and Leasehold Reform Act 2002 came into force. The number of individual occupying lessees who have not yet exercised this right must be very small: nearly everyone who could do it has done it.

The provisions of section 9(1), where they apply, are expropriatory in effect. The landlord is deemed to have to grant a further 50-year lease of the land alone at what is referred to as a “modern ground rent”, and the price payable is then calculated upon that basis.

Intermediate landlords

where the intermediate landlord has a good reversion, that reversion should be deferred at 5.50%, not the 5.00% attributable to a freeholder according to Sportelli;

where the interest of the intermediate landlord had a dynamic element to it, then the flows of rent from the intermediate landlord to the freeholder should be capitalised at a low rate;

in the case of a non-dynamic rent, where the intermediate landlord remains in deficit after the lease extension had been granted, the rate used should be low, but not quite so low; and

in a case where the intermediate landlord remains in profit after the grant of a new extended lease, the positive income flows should be capitalised at dual rates at a reasonable leasehold capitalisation rate, like 6.00% to 7.00%.

Statutory break rights (s61)

When a 90-year lease extension is granted on a flat, it is deemed to include a development break right in favour of the landlord at the old expiry date. This has an effect on the landlord’s interest after the extension in some cases.

Conclusion

Even though the most modern development of leasehold enfranchisement valuation is well over 20 years old, it continues to develop, and remains in a state of flux, despite much guidance from the Tribunals.